US debt deal may be too little, too late

Stephen Foley

Stephen Foley is a former Associate Business Editor of The Independent, based in New York. He left in August 2012. In a decade at the paper, he covered personal finance, the UK stock market and the pharmaceuticals industry, and had also been the Business section's share tipster. Between arriving with three suitcases in Manhattan in January 2006 and his departure, he witnessed and reported on a great economic boom turning spectacularly to bust. In March 2009, he was named Business and Finance Journalist of the Year at the British Press Awards.

Like university students with an essay crisis, members of the United States Congress wired up on Red Bull and coffee worked through the night on their plan to cut the country's indefinitely rising national debt. As The Independent went to press, it looked like they were on course to slip their work under the professor's door by daybreak, averting the default that financial markets always thought was unthinkable. The question, with these last-minute rush jobs, is whether the finished work can possibly get a good grade. And it will be graded.

Is it an AAA piece of work? The professors at the credit-rating agencies have their marking pens poised. Standard & Poor's had already put the US on notice that it is as likely as not to strip the US of its AAA credit rating in the weeks ahead; Moody's said last month that while a default would definitely lead to a downgrade, it was also conducting a wider review of American sovereign debt and the safety of US Treasury bonds.

On the one hand, it might seem extraordinary that the world's largest economy – whose dollar is the world's reserve currency and whose government bonds are used throughout the banking system as a proxy for cash – will be dumped from the elite group of nations whose debt is considered risk-free. On the other, after the shenanigans of the past few days, who can say with a straight face that there is no risk of the US defaulting on its obligation to pay its creditors?

"I am even more convinced a downgrade is coming today than I was yesterday or the day before," said Paul Dales, US economist at Capital Economics in Toronto. "The package that looks to be coming through now falls well short of what is needed. It just depends on whether S&P pulls the trigger this week or later in the year, and what tends to happen is that when one rating agency goes, others tend to follow."

The Budget Control Act of 2011, should it be passed, authorises the federal government to borrow the money it needs to pay its bills, including interest payments to bondholders. It also sets spending caps to reduce government spending by $917bn from what is currently projected over the next 10 years. There will be a further $1.2-$1.5trillion in deficit reduction, either via vicious spending cuts across all departments or from a bipartisan agreement to start tackling long-term problems such as spiralling healthcare spending on baby-boomer retirees and under-taxation.

S&P was staying mum yesterday. It has refused to give a running commentary on the different proposals being thrashed about in Congress, but what is clear is that the current deal falls short of the optimal outcome that the agency said would definitely safeguard the AAA rating. That was a $4trn deal that included some work to tackle long-term issues. Here is what the agency's John Chambers, who will make his recommendation to S&P's sovereign-rating committee soon, wrote last month: "We may lower the long-term rating on the US by one or more notches into the AA category in the next three months if we conclude that Congress and the administration have not achieved a credible solution to the rising government debt burden and are not likely to achieve one in the foreseeable future."

As Peter Orszag, the Obama administration's first budget director, now a Citigroup vice chair, wrote in an essay for Foreign Affairs journal, "rising healthcare costs are at the core of the United States' long-term fiscal imbalance. It is no exaggeration to say that the US's standing in the world depends on its success in constraining this healthcare costs explosion." He is echoing the repeated words of Ben Bernanke, chairman of the Federal Reserve, and countless economists.

The federal debt has ballooned from a historically average 40 per cent of GDP in 2008, before the ill effects of the financial crisis and the Great Recession, to 70 per cent by the end of this year. Why? The size of the economy is smaller than it was before the downturn, tax receipts on this shrivelled base are lower, public spending has reset higher as unemployment benefits have kicked in, and there was a $787bn stimulus package, too, in 2009.

All together, the ageing of the population and the rising cost of health care would cause spending on the major mandatory healthcare programmes and Social Security to grow from roughly 10 per cent of GDP today to about 15 per cent of GDP 25 years from now, the independent Congressional Budget Office calculates.

These mandatory programmes, though, have been punted to a new bipartisan committee, which will suggest long-term tax and spending changes to Congress for a vote around the Thanksgiving holiday in November. If that vote fails, rolling reductions in discretionary spending, including deep cuts at the Pentagon, will ensure an outcome that the White House hopes will spur Republicans into accepting some tax rises as part of a bipartisan deal.

These are the complex issues that S&P, Moody's et al must grapple with. And there is one more. The CBO's debt predictions for the US government are based on assumptions of economic growth over 3 per cent each year well into the second half of the decade. But the GDP figures for the first half of 2011 show the economy performing at below 1 per cent; yesterday's manufacturing figures showed orders have started shrinking; and economists are scaling back their hopes of a gradual decline in unemployment, which is stuck above 9 per cent.

The US finances, already shaky, look weaker by the day.

The Ratings Conundrum

When a country loses its elite status as an AAA-rated nation, financial markets usually take the development in their stride. Economic historians have been scouring the data for parallels as a possible US downgrade looms, and have helped soothe investor concerns. When the US's northern neighbour was cut in 1995, there was no market rout for the Canadian currency, its stock market or for government bonds. Interest rates rose, but incrementally over several weeks, and the government was able to restore its AAA rating after a dose of austerity and market liberalisation.

When Japan lost its top-notch rating from Moody's in 1998, the yen fell less than 1 per cent, while economists attributed a subsequent drift upwards by Japanese interest rates to signs of astirring economy, rather than a bond investors' strike. Research by AllianceBernstein, the investment bank, found insignificant changes to interest rates for all the governments to have lost AAA status since 1990.

The lesson is that global markets are perfectly able to accommodate a patchwork of different sovereign credit ratings around the world.

There is a difference this time, of course, namely the importance of US Treasuries to the plumbing of the financial system, but the consequences of a rating change are hard to predict.

As Howard Wheeldon, analyst at BGC Partners, said yesterday: "Events on Capitol Hill this week confirm another border may now have been crossed – one that suggests the world has changed and that life may never be the quite the same again."